Industry Insight: Smart Phones' Dumb Luck

"Industry Insight" is a weekly series that examines sectors through what's known as the five forces of competition, which can help separate the winners from the losers. Come back every Monday at 6 a.m. to see which industries and companies will be put under review.

You're not cool unless you have a smart phone, apparently.

With a wave of new iPhones, Pres and BlackBerrys hitting store shelves every week, customers' choices are ample. Still, that doesn't translate into profits. The majority of phones will go unnoticed by the masses, leaving companies in no better shape than before they started.

While hit phones can be a gold mine for their manufacturers, the competitive landscape creates an unattractive environment for investors. Due to customers' high expectations and the highly contentious dynamics among competitors, few will prosper while most fall flat.

Palm Pre Smartphone

Here's the breakdown for the smart phone industry:

Degree of rivalry: Rivalry among companies producing smart phones is extremely high. The two biggest players, Apple ( AAPL) and Research in Motion ( RIMM), tend to resort to thinly veiled criticism of competitors' phones. Apple makes the iPhone, and Research in Motion sells the BlackBerry.

After word came from Palm ( PALM) that its latest hope for a revival, the Pre, would be able to sync with Apple's iTunes, Apple shot back by saying that such software loopholes would soon be closed. That came after Apple threatened to sue Palm for allegedly infringing on its touch screen.

Price is usually the most contested issue with most phones selling at razor-thin profit margins. The market is so hot for these phones that companies are willing to make several concessions to gain a foothold with hopes of future success.

Threat of new entrants: Extremely high. A smart phone isn't difficult to make. Any consumer-electronics firm could conceivably produce a phone that will become the next iPhone.

Besides Apple, Palm and Research in Motion, smart phones are available from Nokia ( NOK), HTC, Samsung, Motorola ( MOT), Sony ( SNE) and LG, among others. With these many players and the constant prospect of a new company throwing its hat into the ring, pricing, advertising and design become crucial and, as a result, the phones become less profitable than they would in a less accessible market.

Bargaining power of customers: Most people think the customer is the end user. In the case of smart phones, the wireless carrier is more important. The big three carriers, AT&T ( T), Verizon ( VZ) and Sprint ( S), hold a lot of sway with phone makers, which are desperate to make their phones available to as many users as possible.

Contracts with carriers are crucial for success. Carriers' subsidies are essential to make the phones affordable, yet exclusivity contracts limit the potential market.

While the iPhone is thriving even as it's locked into a contract with a single carrier, AT&T, lesser-known smart phones may die from obscurity on certain networks.

End users, of course, are powerful as well. If a phone is pricey, difficult to use or unattractive, people will pick from the many options that better suit them.

Bargaining power of suppliers: This is one area where smart-phone makers don't get the short end of the stick. Many components in a phone are made by small companies that no one has ever heard of. As a result, suppliers will have little leverage when dealing with massive global companies such as Apple and Research in Motion. Many suppliers win contracts by handing in the lowest bid.

While some big players such as Broadcom ( BRCM) may provide certain components, those parts can be easily replaced from a plethora of semiconductor manufacturers.

Threat of substitutes: Smart phones are substitutes. As an alternative to a traditional cell phone and a scaled-down version of a mobile computer, smart phones give customers a new, more efficient way to communicate.

Until technology makes another leap into the future and some cool new device incorporates a teleporter or a toaster or something, smart phones seem to be relatively peerless.

The rush to cash in on these devices has had the side effect of decreasing profitability. Hot rivalry and a powerful customer base have made success anything but a certainty. Apple and Research in Motion clearly are the top dogs that benefit from name recognition and iconic products. Betting on any other manufacturer is simply too much of a gamble to be worth the risk.

Prior to joining TheStreet.com Ratings, David MacDougall was an analyst at Cambridge Associates, an investment consulting firm, where he worked with private equity and venture capital funds. He graduated cum laude from Northeastern University with a bachelor's degree in finance and is a Level II CFA candidate.

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